Risk, Return, and the Capital Asset Pricing Model (CAPM)

Comprehensive practice questions covering Risk, Return, CAPM, and market efficiency based on the provided lecture notes.

How should an investor determine the best risky portfolio to hold in combination with a risk-free asset?

Choose the portfolio that creates a line from the risk-free rate with the highest slope.

What is the Capital Asset Pricing Model (CAPM) formula for the expected return of a security ($i$)?

$$E(R_i) = R_f + \beta_i(E(R_m) - R_f)$$

According to the CAPM, what should the intercept of the Security Market Line (SML) be equal to?

The risk-free rate ($R_f$)

In the CAPM, what does the slope of the Security Market Line (SML) represent?

The expected risk premium on the market portfolio, calculated as $(E(R_m) - R_f)$

What is the single factor that explains differences in returns across securities according to the CAPM?

The beta ($\beta$) of a security

If an asset's expected return is lower than its equilibrium return predicted by CAPM, how is the asset described?

Overpriced

If an asset's expected return is higher than its equilibrium return predicted by CAPM, how is the asset described?

Underpriced

What are the three main assumptions of the Capital Asset Pricing Model?

1. All assets can be traded. 2. Investors are risk-averse. 3. Investors have homogeneous expectations.

How is the beta of a portfolio calculated?

As a weighted average of the betas of the individual assets in the portfolio.

What are the three common approaches used by analysts to estimate an asset's expected return?

1. Historical approach. 2. Probabilistic approach. 3. Risk-based approach.

What is a primary drawback of the historical approach for estimating expected returns?

The risk of the firm may have changed over time, making past performance an unreliable indicator.

What is an advantage of the probabilistic approach to estimating returns?

It does not require the assumption that the future will look like the past.

What does standard deviation measure in the context of investment risk?

Total risk

Which type of risk can be eliminated by investors through diversification?

Unsystematic risk

What is systematic risk?

Risk that affects many different securities simultaneously and cannot be diversified away.

What is the beta of the risk-free asset?

$$0.0$$

What is the market risk premium?

The difference between the expected return on the market portfolio and the risk-free rate ($E(R_m) - R_f$).

What is the Efficient Market Hypothesis (EMH)?

The idea that asset prices fully reflect all available information.

What is an index fund?

A mutual fund that adopts a passive management style.

How do active mutual fund managers attempt to generate returns?

By performing extensive analysis to identify mispriced stocks and trading more frequently than passive managers.

What is the strategy of 'selling short'?

A strategy used to profit from a predicted decline in a stock's price.